Greg Ip writes at the Wall Street Journal's new Real-Time Economics weblog:
Economics Blog: Why Bernanke's Great Depression Research Matters Today: As an academic in the early 1980s, Mr. Bernanke pioneered the idea that the financial markets, rather than a neutral player in business cycles, could significantly amplify booms and busts. Widespread failures by banks could aggravate a downturn, as could a decline in creditworthiness by consumers or businesses, rendering them unable to borrow. Mr. Bernanke employed this “financial accelerator” theory to explain the extraordinary depth and duration of the Great Depression. (Much of that work was done with New York University’s Mark Gertler, now a visiting scholar at the New York Fed.)
A lot has changed since the 1930s, but the financial accelerator is still relevant. Although Mr. Bernanke doesn’t say so specifically, the record level of consumer leverage today means a change in asset prices (such as homes or stocks) can produce a much larger change in consumers’ net worth, and as a result their ability to borrow and spend. “If the financial accelerator hypothesis is correct, changes in home values may affect household borrowing and spending by somewhat more than suggested by the conventional wealth effect,” that is, the tendency of a changes in asset prices to make consumers feel more or less wealthy, and thus spend differently. That is because “changes in homeowners’ net worth also affect their … costs of credit.”
This tendency of changes in net worth to have knock-on effects on credit availability and spending could “intensify” the effects of Fed actions, Mr. Bernanke said.
Even though bank weakness is less likely to hurt the economy today given banks’ reduced importance as lenders, the financial accelerator is still relevant. That is because “nonbanks” — lenders, such as standalone mortgage companies, that don’t accept deposits — also “have to raise funds in order to lend, and the cost at which they raise those funds will depend on their financial condition — their net worth, their leverage, and their liquidity.”
Mr. Bernanke doesn’t say it, but the current crisis in the subprime mortgage market may be a perfect illustration of the financial accelerator at work today. Many subprime borrowers are facing bankruptcy because their net worth has collapsed and they can’t get new credit. Similarly, numerous subprime lenders have gone bankrupt because they could not get financing to continue operations from newly skeptical Wall Street lenders. As yet, there has been little spillover from these developments into consumer spending or the economy overall. But given his historical interest in the subject, Mr. Bernanke will certainly be on the alert.